Set B · Strategic Cost & Performance Management
Performance Measurement and the Balanced Scorecard
Divisional performance is where Set B turns from costing into management. The examiner wants to know whether you can say why ROI misleads, what Residual Income fixes, and what the Balanced Scorecard adds that neither provides.
Set B · Chapter Notes · 15 Repeated MCQs · Last-day revision
Every measure in this chapter exists because the one before it failed at something. Profit alone ignores the capital used to earn it, so ROI was introduced. ROI creates a perverse incentive, so Residual Income was introduced. Residual Income still relies on distorted accounting numbers, so EVA was introduced. And all of them look only backwards at financial outcomes, which is what the Balanced Scorecard set out to correct. Learn the chain and the chapter organises itself.
The Self-Paced Module Test runs for two hours and carries 100 marks, made up of MCQs with no negative marking. You need 50 percent to pass, and the result is recorded as pass or fail rather than added to your CA Final aggregate. Since nothing is deducted for a wrong answer, never leave a question blank.
Part 1 — Chapter-wise quick notes
Why divisional performance measurement is difficult
- Divisionalisation means decentralising decision authority. It improves speed of response and motivates managers, but creates the risk of dysfunctional decision making where a division optimises itself at the expense of the group.
- Goal congruence is the objective: designing measures so that a manager acting in the division’s interest simultaneously acts in the company’s interest.
- Controllability principle — a manager should be assessed only on items they can influence. Apportioned head office costs and imposed transfer prices routinely breach this.
- Types of responsibility centre: cost centre (accountable for cost only), revenue centre (revenue only), profit centre (cost and revenue), and investment centre (cost, revenue and the capital employed). Only an investment centre can meaningfully be judged on ROI or Residual Income.
Return on Investment
- ROI = Divisional profit ÷ Divisional investment × 100
- Decomposed via the DuPont relationship: ROI = Profit margin × Asset turnover, that is (Profit ÷ Sales) × (Sales ÷ Investment).
- Advantages: a single percentage, comparable across divisions of different sizes, and widely understood.
- The central defect. A manager whose division currently earns 20% will reject a project earning 15% because it lowers the divisional average — even though the company’s cost of capital may be only 12% and the project creates value. ROI encourages under-investment.
- Further problems: sensitive to the depreciation policy and the age of assets. An old, heavily depreciated asset base produces a flattering ROI, discouraging replacement.
Residual Income
- Residual Income = Divisional profit − (Divisional investment × Cost of capital)
- Expressed as an absolute amount, not a ratio. This is precisely what fixes the ROI problem: any project earning more than the cost of capital increases Residual Income, so the manager accepts it. Goal congruence is achieved.
- Limitations: being absolute, it favours large divisions and cannot be used to compare divisions of unequal size directly. It also still depends on accounting profit and book values.
Economic Value Added
- EVA = NOPAT − (Capital employed × WACC), where NOPAT is Net Operating Profit After Tax.
- EVA is Residual Income with accounting adjustments intended to move the figures closer to economic reality. Common adjustments: capitalising research and development and advertising rather than expensing them, adding back provisions and non-cash charges, treating operating leases as debt, and adding back goodwill written off.
- A positive EVA means the division has earned more than the cost of the capital it consumed, and has therefore created shareholder value.
- Market Value Added = Market value of the firm − Capital employed. Conceptually, MVA is the present value of all future EVA.
| Measure | Form | Solves | Still fails at |
|---|---|---|---|
| Profit | Absolute | Simple and understood | Ignores capital employed entirely |
| ROI | Percentage | Relates profit to investment; comparable across sizes | Causes under-investment; distorted by asset age |
| Residual Income | Absolute | Goal congruence in accept or reject decisions | Not comparable across divisions of different size |
| EVA | Absolute | Removes accounting distortions; ties to value creation | Complex; many adjustments; still a single-period measure |
The Balanced Scorecard
Developed by Kaplan and Norton. Its premise is that financial measures are lagging indicators — they report the outcome of decisions already taken. A complete measurement system needs leading indicators as well.
| Perspective | The question it answers | Typical measures |
|---|---|---|
| Financial | How do we appear to shareholders? | ROCE, EVA, revenue growth, cash flow |
| Customer | How do customers see us? | Customer satisfaction, retention rate, market share, on-time delivery |
| Internal business process | What must we excel at? | Cycle time, defect rate, capacity utilisation, cost per unit of process |
| Learning and growth | Can we continue to improve and create value? | Employee training hours, staff retention, new product revenue share, information system capability |
- The four perspectives are linked by cause and effect, running upward: learning and growth enables better internal processes, which improve customer outcomes, which produce financial results. A scorecard without these linkages is just a list of measures.
- Strategy map — the diagram that makes those cause-and-effect linkages explicit.
- Advantages: balances financial and non-financial, short and long term, internal and external, leading and lagging.
- Criticisms: too many measures dilute focus; conflicts between perspectives are not resolved by the framework; measures for learning and growth are hard to quantify; and implementation fails without genuine top management commitment.
Other performance frameworks
- Performance Pyramid (Lynch and Cross) — four levels. Corporate vision at the apex; then market and financial objectives at the business unit level; then customer satisfaction, flexibility and productivity at the business operating system level; and finally quality, delivery, cycle time and waste at the departmental level. Left side of the pyramid concerns external effectiveness, right side concerns internal efficiency.
- Building Block model (Fitzgerald and Moon), designed for service businesses. Three blocks: Dimensions (competitiveness, financial performance, quality, flexibility, resource utilisation, innovation), Standards (ownership, achievability, equity) and Rewards (clarity, motivation, controllability).
- Triple Bottom Line — people, planet, profit. Extends measurement to social and environmental outcomes.
- Benchmarking types: internal (against another unit of the same organisation), competitive (against a direct rival), functional (against a similar function in a different industry), and generic (against the best process anywhere, regardless of industry).
Transfer pricing and its effect on measurement
- A transfer price is simultaneously revenue to one division and cost to another. It therefore redistributes reported profit between divisions without changing group profit at all.
- Minimum transfer price = Marginal cost + Opportunity cost of the transferring division.
- With spare capacity, opportunity cost is nil, so the minimum is marginal cost. At full capacity, opportunity cost is the contribution forgone, so the minimum approaches market price less internal savings.
- Maximum transfer price = the lower of the external purchase price and the receiving division’s net marginal revenue.
- Methods: market-based, cost-based (marginal, full, or cost plus), negotiated, and dual pricing.
- Where divisions are in different tax jurisdictions, transfer pricing also has tax consequences, which is why the arm’s length principle governs it under tax law.
Part 2 — Repeated questions
1. Which is not one of the four perspectives of the Balanced Scorecard? (A) Financial (B) Customer (C) Competitor (D) Learning and growth
(C) Competitor. The fourth perspective is internal business process.
2. A division earns ROI of 20%. The company’s cost of capital is 12%. A project offering a return of 15% is available. What will the divisional manager do if assessed on ROI, and what if assessed on Residual Income?
Under ROI the manager rejects it, because 15% would pull the divisional average below 20%. Under Residual Income the manager accepts it, because 15% exceeds the 12% cost of capital and Residual Income rises. This is the classic demonstration that Residual Income achieves goal congruence.
3. Which responsibility centre is accountable for cost, revenue and capital employed?
An investment centre.
4. EVA is computed as: (A) Profit − Interest (B) NOPAT − (Capital employed × WACC) (C) Sales − Variable cost (D) Profit ÷ Investment
(B) NOPAT less the capital charge computed at the weighted average cost of capital.
5. In the Balanced Scorecard, the cause-and-effect chain runs from which perspective to which?
From learning and growth, through internal business process, to customer, and finally to financial.
6. Under the DuPont analysis, ROI equals ______ multiplied by ______.
Profit margin multiplied by asset turnover.
7. Which measure is an absolute amount rather than a ratio? (A) ROI (B) Residual Income (C) P/V ratio (D) Asset turnover
(B) Residual Income. Being absolute is both its strength (goal congruence) and its weakness (not comparable across divisions of different size).
8. Name the three building blocks in the Fitzgerald and Moon model.
Dimensions, Standards and Rewards.
9. Comparing your process against the best performer in a completely different industry is which type of benchmarking?
Generic benchmarking. Functional benchmarking compares a similar function across industries; generic compares the process itself irrespective of industry.
10. Financial measures in the Balanced Scorecard are described as ______ indicators.
Lagging indicators. The non-financial perspectives supply the leading indicators.
11. A transfer price affects group profit in which way?
It does not affect group profit at all. It only redistributes profit between the transferring and receiving divisions.
12. Which principle states that a manager should be evaluated only on factors within their influence?
The controllability principle.
13. In the Performance Pyramid, the left-hand side of the pyramid deals with ______ and the right-hand side with ______.
External effectiveness and internal efficiency respectively.
14. Market Value Added is conceptually equal to ______.
The present value of all expected future EVA. It is computed as market value of the firm less capital employed.
15. Why does an old, heavily depreciated asset base flatter divisional ROI?
Because the denominator, net book value of investment, has been reduced by accumulated depreciation while the profit numerator is unaffected. This discourages managers from replacing ageing assets.
Part 3 — Recall rail
| Term | what it means |
|---|---|
| BSC perspectives | Financial, customer, internal business process, learning and growth |
| Strategy map | Diagram of cause-and-effect links between the four perspectives |
| ROI | Profit ÷ Investment; causes under-investment |
| DuPont | ROI = Profit margin × Asset turnover |
| Residual Income | Profit − capital charge; achieves goal congruence |
| EVA | NOPAT − (CE × WACC), with accounting adjustments |
| MVA | Market value − capital employed; PV of future EVA |
| Responsibility centres | Cost, revenue, profit, investment |
| Performance Pyramid | Lynch and Cross; external effectiveness vs internal efficiency |
| Building Blocks | Fitzgerald and Moon; Dimensions, Standards, Rewards |
| Triple Bottom Line | People, planet, profit |
| Benchmarking | Internal, competitive, functional, generic |
| Min transfer price | Marginal cost + opportunity cost |
